News & Commentary

Emerging markets pose growth dilemma for investors 17 Mar 10

When you look at the global scorecard for countries and their forecast economic growth one thing stands out clearly: the emerging world is in far better shape in terms of expected future growth than established developed countries.

In many ways that is not surprising given the developed world – particularly the US, Europe and UK – felt the brunt of the global financial crisis. Given that the seeds of the crisis were sown from within the developed world’s financial system deservedly so it would seem.

Central banks, regulators and governments responded to the global crisis with massive amounts of fiscal stimulus and now that a sustained recovery appears to be under way the concerns are switching to the debt that has been built up and in particular how countries like the US, UK and Europe will get their deficits back under control.

So growth forecasts for the developed world – consensus views of economists around the world published by the International Monetary Fund – are muted, albeit probably more positive than we would have thought a year ago. Indeed a modest amount of national pride can be garnered from the fact that Australia tops the growth forecasts out of countries classified as part of the developed world.

So for investors this is raising an interesting question – if most of the world’s economic growth is going to be in developing economies like China, India and Brazil shouldn’t that be where more of my portfolio is invested?

In the very long run it may well be that one superpower – the United States - is ceding its leadership position to a new generation country like China. Just as Britain did when its empire-ruling ways came to an end and the United States powered ahead.

But it is interesting to consider whether forecast economic or GDP growth is also a reliable indicator of long-term sharemarket returns. After all if it was that simple wouldn’t every investor – institutional and individual alike - allocate their portfolio on that basis?

Economic and market analysis done by Vanguard’s Global Chief Economist, Joe Davis, underlines why caution is needed when making these type of judgment calls.

The analysis has found no correlation between forecast GDP numbers and subsequent sharemarket returns.

Using forecast GDP growth numbers as a basis for picking investments – in this case to perhaps underweight the US sharemarket in favor of emerging markets - may well be akin to choosing investments based on last year’s returns. It is not to say the numbers are not interesting and certainly all of the developed nations would prefer stronger rather than weaker growth.

But when you consider how the growth is being derived – and ultimately which companies will profit – the perspective around emerging markets shifts.

The global financial crisis proved one thing conclusively – we live in a highly connected and interrelated global marketplace. And many of the companies that may be well-placed to benefit from growth in emerging markets are likely to be multinational companies based in the developed world.

Those companies – and in particular their shareholders – are putting capital at risk to develop their businesses in new markets so naturally they will have a legitimate call on the profits and capital growth generated.

To underscore that point Davis gives the example of the US railroad boom in the late 1890s. While the British empire may well have passed its peak at that point British investors provided considerable funding and capital. The result was the older, developed country’s sharemarket had an almost identical return for the same period as the then new, developing economy of the United States.

So perhaps the message for investors when it comes to capturing investment market returns look beyond economic growth forecasts and do not be too quick to write off the developed world.